What We’re Thinking

Since Park Piedmont Advisors’ founding in 2003, we’ve been writing a series of Monthly Comments and sharing them with our clients and friends. These original writings cover a wide array of financial topics, as well as our thoughts on the bubbles, booms, busts, and bailouts we’ve guided our clients through.

We are delighted to share these Monthly Comments with you – to illustrate how we believe in thinking for ourselves, not following the herd. For example: to read what we were thinking in the depths of the financial crisis in late 2008 and early 2009, click here and here.

We’ll also be posting new content regularly on this site. We’ve organized our thinking and writing into two categories: Financial Life 101 (for people just starting to learn about these topics), and Financial Life 201 (for those with a familiarity with this material).

There have been many days during the first quarter when stocks have fluctuated, either up or down, more than one percent. Some days, those fluctuations have exceeded two percent. The investment community and media refers to these kinds of large fluctuations as volatility.

We can use the major US stock indexes as illustrations:

With the Dow Industrials at approximately 24,000, a 240 point price change is one percent, and a 480 point price change is two percent.

With the S&P 500 at approximately 2,600, a 26 point change is one percent and a 52 point change is two percent.

And for the NASDAQ Composite at 7,000, the figures are 70 and 140 points, respectively.

During the fourth quarter of 2017, a period of almost no volatility, there was one trading day out of approximately 65 in which prices changed more than one percent. During the first quarter of 2018, there were sixteen days with changes of more than one percent and eight days of more than two percent. (Note: these figures show changes from one day’s closing values to the next day’s closing values; they do not reflect days with large price swings intra-day that end up with modest day-to-day changes).

Even with all this increased daily volatility, for the first three months of 2018 the three indexes showed modest changes, at -2.5%, -1.2%, and +2.3%, respectively. These fairly benign quarterly results mask an approximately 11% decline for the S&P 500 from its Jan 26th high to its February 8th low (2,873 to 2,581). Other significant periods of decline on this index since 2000 include:

First quarter 2000 to October 2002: 1,527 to 777; 49% decline;

End of 2007 to March 2009: 1,468 to 677; 54% decline;

April to September 2011: 1,363 to 1,131; 17% decline;

May 2015 to end of January 2016: 2,131 to 1,940; 9% decline

The media provides daily reasons for these fluctuations (tariffs, budget deficits, rising interest rates, Trump’s problems), but as we wrote last month, most of the time the reasons are after-the-fact explanations for what is really unknown. The media and financial commentators make the current declines seem greater than they actually are, presenting a sense of urgency, if not emergency, to their audiences. Presumably, the more urgency, the more need to take some sort of action, which is what the media wants (keep tuning in), and the financial community wants (keep making transactions).

At Park Piedmont, we believe this incitement to action is the real downside to volatility. Briefly put, when prices fluctuate excessively, investors tend to want to react to the fluctuations, and to do something. These reactions are often detrimental to achieving their long-term investment goals.

One reaction could be to sell the stocks that are declining. History suggests this is not a good idea, because stocks tend to provide the best results compared to the other liquid investments (namely bonds and cash equivalents) over long time periods.

A significant problem investors face after selling stocks is that they do not know when to buy back into the market. Another problem is triggering capital gains taxes if selling is done in a taxable account. Note that some selling may be warranted as part of a well-developed rebalancing program, but rebalancing should not be occasioned by volatility, but should be established in advance of the periods of extreme price changes.

A second reaction is to buy more stocks at the lower prices, assuming the volatility is to the downside. This may or may not turn out to be a good idea based on what happens to stock prices going forward. Noting the extent and length of time for some of the periods of decline shown above, this can be a nerve-racking strategy.

Finally, there is the decision to stay the course and rely on the allocation developed in more tranquil times, which allows investors to essentially ignore the short term volatility. This is of course our view, presented consistently over time. But the decision to stay with, or abandon, investments when they are experiencing sharp price declines involves more than objective factors, which is what makes the volatility so dangerous.

In terms of the causes of volatility, we do not believe the frantic daily buying and selling is being done by longer term investors. Rather, we think much of the volatility is the result of traders who use the stock market as a way to make short term bets. These bets have nothing to do with economics, or politics, or finance, but are simply guesses as to where the next price movement will occur. The volatility these traders generate can lead to inappropriate actions by those trying, instead, to use the stock market as a way to grow their money over time.

In our March 2016 Comments, we referenced an article in the “Your Money” section of the NY Times, written by University of Chicago Professor John List. His general point was that, because of loss aversion (defined in detail below), people underinvest in the stock market. They look at their investments too frequently, and when they see declines, they sell their stock positions to avoid further declines. This behavior occurs even though people are aware of the long-term outperformance of stocks.

As List notes, “[m]arket research shows that when your horizon is not today, not next week, but way in the future, the most profitable strategy is to invest more heavily in riskier assets – stocks – than people are prone to do. So why don’t people invest more in stocks? … Because people are loss averse… keenly more aware of losses than comparable gains… So what can be done? Not paying too much attention to your portfolio is a good first step…” More specifically, List’s advice – which he says he follows – is to look at one’s portfolio no more than once every three to six months. (We might ask the Professor: what is the point of checking even that often?)

We think Professor List’s main point is correct. We would add that extreme volatility leads to investors looking at their portfolios much more frequently than is beneficial to them. In the long term, economic growth rates and corporate earnings are the most important drivers of stock prices. They are not a day-to-day story, but play out over extended time frames, which aligns with the preferred, longer-term timeframe for most investment portfolios.

In sum: try to ignore the market’s volatility, as it is likely to lead to thoughts of making (typically unnecessary, often counterproductive) changes. These changes are unlikely to benefit your long-term investment results.

This month’s Comments provide current examples of an important point we have made regularly in the past: no one really knows the causes for stock prices and their sometimes dramatic changes.

Current case in point: from Friday, February 2nd through Thursday, February 8th, covering only five business days, US stock prices (S&P 500), declined by approximately 9% (2,832 to 2,581, a 251 point decline). The reason given by the media, and other nominal experts, was that likely coming inflation and accompanying higher interest rates were bad news for stock prices (we know they are bad news in the short run for bond prices as well).

But then what happened from February 9th to 14th, over four business days? The S&P 500 regained approximately 4.5% (2,581 to 2,699, a gain of 118 points), even as the economic reports continued to show higher inflation and higher interest rates (along with continuing lower bond prices).

How can stock prices decline in one week, and gain in another week, with the same stated reason for the price changes? Since that is not logically consistent, there must be some flaw in presenting the cause in the first instance. Our view at Park Piedmont is that causation of stock price changes is extremely difficult to pinpoint, and even when there is widespread agreement as to a reason, the conventional wisdom is often wrong.

A second, more recent example covered four business days between February 28th and March 5th. On the 28th, President Trump announced, surprisingly, the imposition of tariffs, going against most conventional economists who typically oppose tariffs. Stocks proceeded to fall approximately 1.5% (2,714 to 2,678 on the S&P 500), and the media and other pundits were sure tariffs were to blame. Three days later, stock prices were higher (at 2,721) than the day before the decline, and tariffs were still to be imposed. Then Trump’s economic adviser Gary Cohn resigned over the tariffs on March 6th, and the pundits predicted serious declines due to that event. But there were no declines at all. Events that the media claim as causation for falling stock prices are often incorrect. And, at times, the predicted events do not even occur.

To show this is a common occurrence in media reporting, remember back to Trump’s most surprising election victory, and our Comments (October 2016) at that time:

An excellent example of the “herd mentality” related to the certainty of significant declines appeared in the NY Times on election day (11/8/16, page B1), in an article titled, “What the Election’s Results Will Mean for the Markets,” by highly respected financial columnist Neil Irwin. The article begins: “What will happen to financial markets after the election? More so than usual, we have a decent idea. That’s because there has been a clear and identifiable swing in a variety of asset prices – especially the stock market and currencies – at inflection points in the presidential race. A stock market rally on Monday is the latest evidence, and appears to be linked to the FBI announcement that an examination of newly discovered emails tied to Hillary Clinton revealed nothing warranting charges.”

And in a post-election NY Times article (11/11/16, page B1), James Stewart, another well-respected financial columnist, wrote: “To the long list of pundits who called the election all wrong – as well as its consequences – add Wall Street analysts.” He cites predictions of 11-13% declines, and 2,000 points on the Dow (approximately 11%), and observes that “with the benefit of hindsight, what’s extraordinary is how few professional investors saw it coming. Trump was derided as the candidate of uncertainty, which markets typically abhor…. But there was nothing uncertain about his overall pro-growth, pro-business and American-first tendencies, now backed by the firepower of a Republican House and Senate.”

To us at Park Piedmont, this simply reinforces the absolute futility of making predictions. This is not to pick on Mr. Irwin or the NY Times; it’s simply to illustrate, once again, the real problem that we as consumers of financial information face. We are unable to distinguish between what does and does not make sense, even in well-written articles by presumed experts.

Reviewing some of the key points we made in our March 2017 Comments, we reiterate the following:

The factors that move stock prices are many and varied. In our view, there is no way to explain day-to-day stock price movements with any one or two explanation points (e.g., Trump’s economic legislation agenda under attack). If that’s the case, then why does the media find it necessary to report on the markets as though they were a single sporting event, providing an often incoherent narrative (e.g., a slow trading day suggests that portfolio managers acted earlier in the week)?

There is no way a Times reporter – or any reporter, for that matter – can accurately “know” what “investors” are thinking, and what makes them act, and report as if the claim is accurate. The results of any day’s stock price movements are the results of the activity (and inactivity) of many thousands of market participants – professional and amateur, traders and long-term investors. Who could possibly know what ideas are moving each of them to do what they do each day, let alone report on the “market” as though it’s an independent entity with its own intentions?

It’s also hard to understand how the media can report that one day such-and-such-a-factor caused the market to move in one direction, and the next day, when prices move in the opposite direction, report that investors ignored the factor so essential the day before.

Bad news is almost always emphasized, which tends to make people nervous and more likely to change their investments, rather than act as long-term investors with a time horizon of years, not minutes. Bad news may sell more newspapers, but emphasizing bad news can lead to adverse results by suggesting to investors they should take action in light of the news, rather than taking the longer-term view. Much of the investment literature supports the view that the fewer changes made to a portfolio based on reacting to current news items, the better the long-term outcome.

Market reporters feel the need to infuse an article about market activity with explanations. Humans like stories; we at PPA are no exceptions! But rather than report the reality, which is that prices change day-to-day for many reasons, none of which are clearly or independently verifiable, at least most of the time, a narrative develops as an after-the-fact explanation of events.

In the long term, economic growth rates and corporate earnings are the most important drivers of stock prices (mentioned ever so briefly in some of the daily reporting above). They are not a day-to-day story, however, and are difficult to capture in daily reporting. Instead, they play out over extended time frames, which aligns with the preferred, longer-term timeframe for most investment portfolios.

In sum: try to ignore most of the media’s day-to-day reporting on market activity, as it is likely to lead to thoughts of making (typically unnecessary) changes, and therefore unlikely to benefit your long-term investment results.

As stock prices continue their recent sharp fluctuations, mostly to the downside, we are writing again with more information (research from Guggenheim Investments), to present a long term perspective.

From year-end 1945 to year-end 2017, covering 72 years and using the S&P 500 index (note: S&P 500 index and Dow Industrial average often have similar percentage price changes), there have been:

77 declines (approximately once a year) of 5-10%, with an average decline of 6%, covering one month and taking one month for the declines to recover to the price level at the start of the decline;

27 declines (approximately once every two to three years) of 10-20%, with an average of 14%, covering four months, with four months for the declines to be recovered;

8 declines (approximately once every nine years) of 20-40%, with an average of 27%, covering eleven months, with fourteen months for the declines to be recovered;

3 declines (approximately once every twenty four years) of more than 40%, with an average of 51%, covering twenty-two months, with fifty-seven months for the declines to be recovered.

The current decline on the S&P 500 (to 2,581 as of the close on February 8th) has now reached 10.2% from its January 26th all-time high of 2,873 (the Dow Industrials have gone from a January 26th high of 26,617 to a February 8th close of 23,860, a decline of 10.4%). Which of the above categories the current decline will eventually fall in is as yet unknown, and this represents the risk associated with stock investing.

The media and financial pundits try to attribute reasons for the declines, such as: (A) an economy that is doing so well that it may cause the Fed to raise interest rates to a level that negatively affects stock prices (see our January 2018 Comments for more on this subject), or (B) traders using highly leveraged products based on volatility, or (C) some other rationale designed to fit the event after the fact.

But perhaps the reason for these declines is simply that stock prices had gotten too high.

To elaborate, the last significant decline before this one (Jan-Feb 2016) reached 11%, and was followed by two years of extraordinary gains. At the January 26th, 2018 high, the S&P 500 index had advanced from 1,829 to 2,873, a gain of 57% (the Dow rose from 15,660 to 26,617, a gain of 70%).

Finally, note the impact of asset allocation: for younger clients not currently using their money, an allocation of 70% to stocks means 30% is not affected by the stock declines, and for older clients who might currently be using their money, a 35% stock allocation means 65% is not affected by the declines. An important part of our work at Park Piedmont Advisors is to develop and follow allocations designed specifically for each of our clients.

Last month in our discussion of interest rates, we stated that ”one major interest rate story for the year 2017 deserves additional comment: the fact that while there were three one-quarter point increases in the short-term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%.” One month later, we see the ten-year yield at 2.71%, a substantial 30 bp rise in one month, clearly indicating that the buyers and sellers of bonds believe interest rates are on the rise. The question now is how much further rates will rise, and the speed at which they do so. As discussed below, a long, drawn-out rate increase should have less negative impact on portfolios by reducing the short-term price declines and thereby allowing the higher rates to offset the lower prices more quickly.

More generally, when interest rates rise, bond prices fall, with more price impact on longer maturity bonds. The tradeoff, as we wrote last month, is that investors owning longer maturity bonds typically earn additional income in return for their willingness to absorb larger price declines in the bond portion of their portfolios, compared to the smaller price declines that occur with shorter-term bonds that pay less interest. These bond price declines, should they occur, are typically modest compared to the extent of potential stock price declines, and bond price declines are offset in part over time by the higher interest received.

This brings us to the discussion of how interest rates impact stock prices. Our first observation is that the connection between interest rates and stock prices is far less clear than the direct impact of interest rates on bond prices. Stock prices are affected by a host of factors, such as the pace of economic growth, expectations of corporate profits, and investor psychology as to the likely future direction of market prices. Interest rates therefore are but one of a number of factors to consider in relation to stock prices.

When economic growth is strong, and corporate profits are increasing, it makes sense for stock prices to rise. But if growth becomes too strong, the Federal Reserve typically raises interest rates in an effort to slow the growth down and avoid (or at least mitigate) the harmful effects of inflation. How does this work in practice? Higher interest rates can slow economic growth by raising the cost of borrowing, which in turn tends to slow spending and reduce corporate profits. In the financial markets, when rates rise, bond prices fall and interest rate payments increase, setting the stage for potential stock price declines, as bonds become a more attractive investment.

The key point to recognize is that in the liquid markets, stocks and bonds compete for an investor’s accumulated savings. Stocks represent an ownership stake in a company’s future profits and offer the potential for significantly higher appreciation (see the period from 2009 to the present), even with significantly more downside risk (see 2008 through March 2009). Investment returns from stocks come from price appreciation (or depreciation) and dividends. Bonds, on the other hand, are a promise to repay a set amount of money in the future, plus interest, and the investment return comes mostly from the interest, with modest price changes (depending on the maturity) until the bonds mature.

When interest rates rise in the marketplace, and bond prices decline, this creates an opportunity for a flow of more income from the higher interest payments, and some number of investors become more likely to reduce their riskier stock holdings and increase the steadier bonds now paying more interest. This provides a rationale for stock price declines even in the face of strong economic growth and strong profits. Of course, how much the prices decline and for how long are always unknowns.

This brings us to a recent “Opinion” article by Professor Burton Malkiel (author of the many editions of “A Random Walk Down Wall Street) on “How to Invest in an Overpriced World”. The article begins by stating that “all asset classes appear overpriced;” bonds because of their low yields and stocks because of their historically high price earnings (P/E) ratios. “Investors have reason to worry, but they need to be aware of two basic facts. First, no valuation metric can dependably forecast the future…. A corollary is that no one can consistently time the market… which involves two decisions, when to get out and when to get back in. Timing both correctly is virtually impossible.”

Malkiel continues by discussing two strategies that can control risk, namely broad diversification and rebalancing. “Broad diversification…. By holding a wide variety of asset classes, investors have historically enjoyed smoother gains during bull markets and gentler losses during bear markets. In a diversified portfolio, declines in stocks are often partially offset by stability in fixed income markets…. Real estate equities, available through REITs, have also tended to stabilize portfolio returns…. Internationally diversified portfolios, including emerging markets, also tend to see less volatile returns over time and better risk adjusted performance.” Additionally, “Rebalancing helps control risk by ensuring your asset allocation has not strayed far from your desired levels. If the strong US stock market has lifted the proportion of domestic stocks in your portfolio to levels that are riskier than desired, it would be appropriate to reduce your equity share…. In general, staying the course in a broadly diversified portfolio is the best strategy when all asset classes appear overpriced.” He then suggests REITs and higher-yielding preferred stocks as potential replacements for positions sold while rebalancing.

The article closes with the advice to keep costs low, and avoid paying one percent for the investments and an additional one percent for the advice. He “recommends passive index funds and exchange traded funds, now available at virtually zero expense ratios, as the best investment vehicles for all investors.”

At Park Piedmont, we are advocates of Professor Malkiel’s advice, and recommend a broadly diversified mix of short and intermediate maturity bonds, along with high yield investments, and a mix of US (including REITs) and international/emerging market stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds and ETFs. Periodic rebalancing, a fiduciary relationship with our clients, and advisory fees at the low end of the profession’s fee schedules have all been key aspects of our work on behalf of our clients since our founding some fifteen years ago.

Whenever stock prices experience large short-term declines, we make sure to check in with you to put the declines in perspective. The chart at the bottom of this memo provides figures that should help.

The media likes to present large numbers in its reporting, but the focus should always be on percentages. Using end of January 2018 price levels, a 1,000 point decline in the Dow is less than 4%. This is comparable to a stock you own going from 100 to 96, a change you might not notice that much.

Since the end of 2014, there have been two periods (August 2015 and Jan-Feb. 2016) of declines of 12%, which would be 3,000 points using the end of January 2018 price levels. Do you even remember those periods?

Stock prices have had very large gains since the 2016 election, up approximately 7,800 points to the end of January 2018, which was a 42% gain since the election. Even with the declines of the last two weeks, stock prices are close to year-end 2017 levels.

Some kind of stock price correction has been anticipated for many months now, as prices kept going higher. How much stock prices are likely to decline, and for how long, is of course in the realm of the unknown, although the media and the financial community will certainly provide their guesses.

Note that stock prices have gone up in periods of both increases and declines in 10-year Treasury yields. These yields have increased significantly since the end of 2017.

Stock Index % Changes, and US Treasury % Changes

End 2014 to Feb 5, 2018 (Using end 2014 as base year)

DJ Indus

S&P 500

NASDAQ

10 yr USTr

End 2014

17,823

2,059

4,736

2.17%

Aug 2015

15,666

-12.1%

1,868

-9.3%

4,506

-4.9%

2.08%

End 2015

17,425

-2.2%

2,044

-0.7%

5,007

5.7%

2.27%

Jan-Feb 2016

15,660

-12.1%

1,829

-11.2%

4.267

-9.9%

1.64%

Election Nov 2016

18,333

2.9%

2,140

3.9%

5,193

9.6%

1.86%

End 2016

19,763

10.9%

2,239

8.7%

5,383

13.7%

2.45%

End 2017

24,719

38.7%

2,674

29.9%

6,903

45.8%

2.40%

Jan 31, 2018

26,149

46.7%

2,824

37.2%

7,411

56.5%

2.73%

Feb 5, 2018

24,345

36.6%

2,649

28.7%

6,967

47.1%

2.73%

Our general advice to firm clients is to stay the course, avoid attempts at market timing, and rely on asset allocation (specifically, the percentage of one’s portfolio not invested in stocks) to soften the extent of the declines.

Since Bitcoin has become a very popular topic of discussion in and out of the financial world, we thought it was time for Park Piedmont to add our viewpoint. As you might imagine from a firm that advocates long-term investing with asset allocations implemented using low cost index funds, even the mention of Bitcoin would be highly questionable. Nevertheless, we outline our perspective below.

We start by referencing Warren Buffet, who is among the best, if not the best, investors of our time. A December 2017 article from WealthAdvisor.com (http://bit.ly/wb1227), quotes Buffett as saying: “You can’t value bitcoin, because it is not a value-producing asset…” (In 2014, Buffett said, “the idea that it has some huge intrinsic value is just a joke….”)

The Wealth Advisor article notes that “Bitcoin is a complex idea. It is a virtual currency, created, owned and traded entirely online in anonymous and unregulated settings. In theory, there is a limited number of these physically non-existent digital coins, though that limit hasn’t yet been reached. A few years ago they were almost worthless; in December 2017, their value reached $19,000.”

The article states that “what drives the value of an essentially value-free asset is – FOMO – the fear of missing out,” and explains that the intrinsic value (of an investment) is a continuous flow of actual cash from the operation of a business (referencing Buffett for this principle), and that “the ultimate source of cash flow from digital coins created on the internet is the dollars flowing from the buyers who want to own those coins, for FOMO.”

Echoing this view is Professor Robert Shiller, the former manager of Yale’s endowment, who foresaw the housing bubble of 2007-08. In a recent New York Times article (http://bit.ly/shillerbc), Professor Shiller wrote, “True investing requires a rational appraisal of an asset’s value, simply not possible at present with Bitcoin. Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent…. No one can attach objective probabilities to the various possible outcomes of the current Bitcoin enthusiasm.”

One problem in Bitcoin’s potential use as a currency is the extreme volatility of its price. This was illustrated on 12/22/17, when the price went from $17,500 to $12,000 in a single day, a decline of approximately 30%. (A similar decline on the Dow Jones, at 25,000, would be 7,500 points). In the same article describing this price decline (https://nyti.ms/2DsEc97), the reporters commented that “Bitcoins have mostly been treated as an investment because there is a cap of 21 million on the number of Bitcoins that will ever be released.” Aside from the obvious question of whether someone can actually ensure that the cap is maintained, an even more fundamental objection to the Times article is that a numerical cap on the supply of some object does not by itself create any value in the object. Even if self-described as a currency, why would anyone treat it as a currency without some underlying economic unit to support its value?

Investment News, a weekly magazine mostly for investment professionals, wrote about Bitcoin (12/4/17) that “rarity can bid up prices, but even though Bitcoin limits its issuance to 21 million coins, there are some 100 other cryptocurrencies.” The article concludes that “it is hard to imagine a practical reason for owning bitcoin, aside from trading, or hiding criminal activity” (http://bit.ly/inbc124).

Two recent NY Times articles provide excellent examples of the validity of the Investment News observations. In a front-page article (https://nyti.ms/2E2KLim), the Times reported that “Russian and Venezuelan officials are hoping virtual currencies can help their countries make an end run around American sanctions. Both governments … are looking to take advantage of the promise that Bitcoin introduces to the world financial system: a new kind of money and financial infrastructure, outside the control of any central authority, particularly the United States…. But economists and virtual currency experts have given these currencies low probability of success … because Bitcoin and other virtual currencies are decentralized systems with no one in charge, while Russia and Venezuela would give leaders of both countries a measure of control over the new currencies.” And in another NY Times article (https://nyti.ms/2E8fFpk), it was reported that the virtual currency Ripple has increased more than 30,000 percent in the last year, making the “largest holder of ‘Ripple tokens’ worth more than $59 billion.” (Yes, that’s billions).

If this isn’t a “bubble” of manic proportion, we don’t know what is.

INTEREST RATES, UPDATED

One major interest rate story for the year 2017 deserves additional comment: the fact that while there were three one-quarter point increases in the short term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%. The implications of this fact are discussed below.

Some context for this discussion: a key point in understanding bond price changes is that when market interest rates change, the longer the maturity, the more the price fluctuation. An example of this relationship follows: if market rates rise to 3%, a bond yielding 2% today and maturing in two years, will decline less than a bond yielding 2% today and maturing in six years, because investors get their money back sooner to reinvest at the higher rate with the shorter, two-year maturity.

Given this basic fact of bond investing, the question is how much more yield (interest income) do longer-term investors have to receive to be compensated for the extra price risk being taken? In today’s bond market, the spread between a three-month US Treasury yielding 1.4% and a ten-year US Treasury yielding 2.4%, is quite clearly 1.0%. So the question is: why would presumably rational investors take the risk of owning a bond for almost ten more years just to receive 1% more interest?

The explanation, to the extent there is one, is that the ten-year investors think that future yields will be going down, not up, in which case the longer-term bond becomes more valuable, and its price increases. These investors may be right, if economic growth slows and inflation remains low. (Our note: Inflation is the declining purchasing power of a currency over time, and interest is one way investors are compensated for receiving currency with less purchasing power in the future).

In the current environment of an expanding economy, high employment, a recently enacted tax bill that many observers believe is likely to increase the budget deficit and increase inflation, and a Federal Reserve seemingly poised to raise short-term rates again in 2018 (the consensus is for three more quarter point increases), the 1% spread between 3-month and 10-year bonds seems quite small.

Many investors looking for additional income from the longer maturity bonds are likely to absorb price declines in the bond portion of their portfolios if rates rise. Smaller price declines would come from shorter-term bonds, but that would reduce the income from the portfolio. These bond price declines, should they occur, are typically modest compared to possible stock price declines, and the bond price declines are offset in part by the higher interest received on bond portfolios.

At Park Piedmont, we suggest a mix of short and intermediate bonds, along with high yield investments and stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds.

As you may know, the Levinsons are pretty big baseball fans. Vic and Nick actually coached Tom’s little league teams (photos are available upon request), and Nick and Tom (and their sister Lynn) grew up going to Yankees games on the 4 train in the 70s and 80s. So there was some excitement upon the announcement, made this past weekend, that the Yankees had traded for Giancarlo Stanton, the reigning Most Valuable Player in the National League.

In the article on espn.com breaking the news, an interesting detail popped out: when Stanton was drafted back in 2007, he was the 76th player selected. Stanton is a towering slugger and four-time All Star. Yet, a decade ago, the teams of Major League Baseball selected 75 other players before him. Amazingly, of those 75, over twenty never played a single game in the Major Leagues.

How did so many teams, tasked with the most expertise and up-to-date information, get their predictions so wrong? Some players got injured, as you’d probably expect. Elbows wear down and knees give out. Some others just didn’t improve the way teams expected them to – in some cases the shortcomings were likely physical; in others, mental; in still others, both.

But the real answer is that fortune-telling is exceedingly hard.

At year’s end, forecasts for the year to come are everywhere. That’s especially the case in the financial markets. With various stock indices at or near all-time highs, analysts and pundits declare that it’s only a matter of time before a significant stock decline. “Whoa,” say other commentators, “why so gloomy?” With a growing economy both here and abroad, unemployment down, and significant tax legislation on the brink of passage, these observers exude confidence that there’s plenty of room for markets to rise.

Many – including many who are smart and sophisticated – attribute significance to the predictions. They base their actions on these predictions. They rely on them. Indeed, much of the investment advisory industry relies on the ostensible predictive ability of researchers and stock pickers, portfolio managers and quants. Are they reliably right?

No.

According to the S&P Dow Jones Indices Persistence Scorecard, very few funds consistently outperform their benchmarks. The 2016 Scorecard reports: “Out of 631 domestic equity funds that were in the top quartile as of September 2014, only 2.85% managed to stay in the top quartile at the end of September 2016. Furthermore, 2.46% of the large-cap funds, 2.20% of the mid-cap funds, and 3.36% of the small-cap funds remained in the top quartile.”

In other words, roughly 97 percent of the active managers who are paid (handsomely) to outsmart the future failed to, even over a 2-year period. Jeff Sommer’s March 2015 column in the New York Times memorably explored this same territory.

Researchers have found that in various fields, experts have a hard time forecasting what’s to come. In a September 2011 episode of the Freakonomics podcast called “The Folly of Prediction,” Philip Tetlock, a professor of psychology and management at Wharton, explained that a signature challenge for experts lies in “think[ing] they know more than they do.” They tend to be “systematically overconfident.” As much of the field of behavioral economics continues to reveal, humans are predisposed toward emphasizing data that supports our positions, our viewpoints, and our biases, and undervaluing data that challenges those positions.

Frequently in conversation, the question is asked: where do you think the markets (or interest rates, or the economy) are going? You likely know our answer by now: we don’t know.

Park Piedmont has a deep institutional humility about our ability to forecast what’s to come in a complex world. It’s why our Comments routinely feature Larry Swedroe’s observation that “the biggest mistake investors make is treating the highly unlikely as impossible (such as having a massive crisis), and the likely almost as if it is certain (such as the probability that stocks will outperform bonds over twenty years).” It’s why we emphasize customized, broadly diversified asset allocations for you, our clients, in a way that’s respectful of your risk tolerance and designed to help accomplish your long-term goals.

It’s also why you won’t see us placing a wager on the Yankees’ World Series chances in 2018 after their blockbuster trade – even if that’s what the experts are predicting.

Last month we changed our focus from the surprising, ongoing advance of stock prices since the 2016 election, to bonds, the other major asset class in most client portfolios.

During September there was a substantial increase in market interest rates, which brought the benchmark ten-year US Treasury yield to 2.34%, up 21 bps from August’s close of 2.13%. October’s increase was a much more modest 4 bps, to 2.38%, still below the year end 2016 rate of 2.45%, even as the Federal Reserve has made two 25 bps increases (in March and June) in the ultra-short term overnight rates it controls during 2017.

Ordinarily, an increase in rates by the Fed would result in a similar increase in longer-term rates set by bond market buying and selling. Surprisingly, this has not occurred so far in 2017. A new Fed Chairman replacing Janet Yellen, and a likely additional 25 bps short term rate increase by the Fed in December, provide some additional context to this discussion.

We are going to use Jeff Sommer’s recent article on bonds (NY Times, 10/29/17 Sunday Business, page 3) as background for our Comments.

The article observes, as we often do, that “Stocks and bonds are complementary partners in standard portfolios. While stocks typically have a higher return potential, bonds are generally less risky and provide a hedge against a stock market plunge, as they did during the bear market that started in 2007.”

PPA’s addition: the extent of the stock decline (and subsequent recovery) are most noteworthy, and add important detail to the rather bland statement of a “bear market that started in 2007.” The S&P 500 index declined from its October 2007 high of 1,565 to a March 2009 low of 677, a decline of 57%. That same index closed October 2017 at 2,575, a gain from low to high of 280%. This is an annualized gain of approximately 17% over the 8.5-year period.

The article continues that “despite a rocky bond market over the last month, bond prices are still too high, and their yields so low, that bonds simply can’t provide much buffering.”

PPA’s addition: we respectfully disagree. If long term market history is any guide, when stock prices fall 20% (the definition of a bear market), or more, the declines in bond prices attributable to rising interest rates are likely to be much, much smaller, and that is the whole point of owning an appropriately allocated and diversified portfolio of bonds and stocks.

The article then continues with a discussion of the wonderful returns in stocks over the last eight plus years, and whether they are likely to continue.

PPA’s addition: surely no one knows the answer to this question.

The article then returns to another recent article by the author: “the standard practice after a big run up in stocks is to rebalance, meaning to take profits out of stocks and put them into bonds. The goal is to create a well-diversified portfolio … the problem is that this is not an ideal moment to be putting money into bonds.” Reasons for the continuing upward pressure in interest rates are presented, ranging from the Fed’s desire to raise rates gradually to ward off future inflation, to the Fed program of selling bonds it had purchased in the aftermath of the financial crisis, to the identity and likely policies of the new Fed chairman, to the potential inflationary impact of the larger budget deficits coming from the government, including from possible changes in the tax law.

Sommer continues that “the bond market turmoil leaves investors in a bit of a muddle. The central reason for holding bonds remains intact: Bonds will still buffer a portfolio and generate income. But in the near future, they aren’t likely to do so as effectively as in the past.”

PPA’s addition: if the point of bonds is to offer a buffer against serious stock market declines, investors should focus on this purpose, and be less concerned about whether this is or is not a good time to buy bonds based on their future return potential.

The Sommer article concludes with some observations from John Bogle, the founder of Vanguard, one of which is that “compared to stocks, bonds are a good value, better than they have been in years … and it still makes sense to hold stocks and bonds in a diversified portfolio.”

PPA’s addition: we take no position on the relative valuations of bonds and stocks, but certainly agree that a diversified portfolio of stocks and bonds, allocated to the investment goals and risk tolerance of each investor, is the best defense against the unexpected (refer to Larry Swedroe’s observations about asset allocation above).

A few other comments may prove useful:

Rebalancing (adding to bonds after large stock price advances) “is more a risk control measure than a return generator.” (This quote comes from Sommer’s article on rebalancing, and we agree. Note there is no mention in the quote of whether this is a good or bad time to own bonds, just that owning them is intended to provide risk control.)

Investors expect to receive higher interest rates on their bond investments when inflation rises, to offset the reduced purchasing power of the money they receive when their bond investments mature. So when rates do rise, and bond prices decline, one other result is that investors receive higher interest payments in the future.

The extent of price declines depends on maturities of the bonds, and on the amounts and time intervals of the interest rate increases.

We are always available to discuss these issues in more detail, including how to balance stock and bond allocations in each client’s portfolio.

A recent article by Wall Street Journal columnist Jason Zweig, entitled ‘Don’t Touch My Money, Just Hold My Hand’ (WSJ, June 9, 2017), touched on topics that reinforce the investment approach Park Piedmont has been conveying to clients since its founding in 2003.

First: many people look to investment advisers to boost their investment returns. If that’s your perspective, “you may be paying your adviser for the wrong thing,” according to Zweig. Just as investors tend to be their own worst enemy by “flinging money at whichever assets have gone up the most and then bailing out at the bottom, locking in losses” – typically during periods “when they are in the grip of greed or fear” – many advisers, driven by the perceived need or desire to outperform, act the same way. In their efforts to chase performance, advisers can lag significantly behind those who maintained a discipline in maintaining their long-term plan.

Second: investors often feel the urge to do something, when nothing may actually be a better investment decision. Zweig writes that investors tend to add and subtract money at inopportune times, leading to “what is often called the ‘behavior gap’ between the performance of an investment and its investors.” For instance, mutual fund investors earn average annual returns that are approximately 1 to 1.5 percentage points lower than the returns of the funds themselves. Zweig adds that investors in hedge funds “may lag those vehicles by up to 7 percentage points annually.” That’s what a financial adviser “should prevent,” writes Zweig.

Finally: Mr. Zweig closes his piece with the following quote, which further reinforces another of Park Piedmont’s consistent message to our clients. “You should hire an adviser not for his or her investing prowess, but to help organize your finances, prioritize your goals, minimize your taxes, and navigate the shoals of retirement and estate planning. Done right, those services can make you far richer – and happier – than the pipe dream of investment outperformance is likely to.”

There will always be events that affect the market in the short-term, in both positive and negative ways. But an adviser can give clients confidence and help them maintain their discipline, so that short-term events don’t undermine longer term goals.

Please contact us if you’d like more information about how Park Piedmont Advisors, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.

At Park Piedmont Advisors (PPA), we advise clients that trying to predict future events, and the financial market’s reactions to future events, can often lead to disappointing results. Rather, we advocate ignoring most current events and focusing instead on long term financial goals and the cost efficient investments that help achieve those goals.

Here is an example of how even knowing future events can lead to disappointing results.

On Monday May 23, 2016, the US S&P 500 index was 2,048.

Since then, we have experienced the following events- some surprising- that, to most observers, would have been considered negative for financial markets:

Assuming you were able to predict the future and knew all this was going to happen, would you have thought the US stock market, as measured by the S&P 500 index, would be:

a) closer to 1800 (approximately 12% lower than mid May 2016);

b) 2100 (approximately the same as mid May 2016); or

c) 2300 (approximately 12% higher than mid May 2016)?

Of course, we now know the answer is the 2300, but who would have thought that before the fact?

The moral of the story is to try and ignore the short term news, and focus instead on your long term goals. This is the ongoing message PPA provides its clients. Contact us to learn more about our investing approach.